Influence of Mental Accounting on the Financial Well-Being of Young Adults

What Is Mental Accounting?

The concept of mental accounting was first introduced by “Richard Thaler” in his paper, namely, “Money and Mental Health”. This was published in the “Journal of Behavioural Decision Making” (Thaler, 1999). Thaler argued that people place value on money in different ways and this can lead to irrational decisions. It says that people classify money on subjective criteria and based on that, they can make their financial decisions (Zhao & Bacao, 2021). According to Thaler, unexpected money is more likely to lead to impulsive spending because it wasn’t factored into their financial plan. In 1999, Richard Thaler coined the term “mental accounting”. The term was first published in a paper called “Mental Accounting Matters” (Thaler, 1999). In the paper, Thaler discusses mental accounting cause people to make irrational decisions about spending and investing. He defines mental accounting as a series of cognitive operations that people use to track their financial activities.

Thaler refuted the mental accounting theory by emphasizing the fungibility concept. Fungibility is the idea where it defines that people should treat all their money with the same value, no matter what it is used for or where it comes from. When people have a windfall, such as a bonus, tax refund, lottery win, or birthday money, they often spend it on extravagant expenses that they can’t justify. That’s why the author suggested that people treat all their money as fungible and spend windfalls in the same way they would spend regular income on a well-thought-out financial plan (Rooh et al., 2021). According to mental accounting, money is treated differently depending on where it’s coming from and what it’s going to be used for. A key concept underlying mental accounting is fungibility. Even experienced investors are prone to this bias, viewing recent gains as 'house money' that can be used for high-risk investment opportunities (Knapp & Wong, 2020).

Mental accounting is about treating the same thing – especially money – differently, depending on where it’s coming from or what the individuals are going to use it for (Sattar et al., 2020). It can also cause them to focus on one account at the expense of the rest of their finances. All money is fungible, but mental accounting prevents individuals from treating it as such, leading them to separate assets into different “accounts,” both metaphorically and literally (Cao et al., 2021). The temptation to “classify” their windfall, for instance, into a separate mental account from other sources of income can be a major threat to their financial health. It has been already heard about the staggering rate at which lottery winners go bankrupt or the fact that 80% of pro athletes burn through their assets within three years of retirement (Kartini & NAHDA, 2021).

There are three main parts to mental accounting. The first is about how outcomes are seen and experienced. The second is about making and evaluating decisions. For example, buying the quilt, the consumer’s choice is understood by consisting of the value in the ‘deal’. The third part of mental accounting is about assigning activities to particular accounts. Both the source and use of funds are identified in real accounting systems (Ángeles López-Cabarcos et al., 2020). The first two examples above illustrate aspects of the categorisation process of mental accounting (Rasool & Ullah, 2020). For example, a vacation in Europe is made less painful because it is possible to set up a 'European Vacation mental account' from which the expenses could be deducted.